step one establishing an entity the right type in the right place at the right time
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Step One: Establishing An Entity The Right Type in the Right Place at the Right Time. Presented by: Quin H. Breland Baker Donelson [email protected] 504.566.8627. The Right Type – Choice of Entity. Primary considerations: Nature of business Number of owners

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step one establishing an entity the right type in the right place at the right time

Step One: Establishing An EntityThe Right Type in the Right Place at the Right Time

Presented by:

Quin H. Breland

Baker Donelson

[email protected]


the right type choice of entity
The Right Type – Choice of Entity
  • Primary considerations:
    • Nature of business
    • Number of owners
    • Role of owners (active or passive)
    • Allocation of profits, losses, and cash flow
    • Ability to attract outside capital
    • Taxation
  • Other considerations:
    • Cost of organization
    • Formality of governance
    • Transferability of ownership interests
    • Continuity of existence
    • Ability to attract and retain management and employees
    • Estate planning objectives
common forms of organization
Common Forms of Organization
  • Sole proprietorship
  • General partnership
  • Limited partnership (LP)
  • Corporation
    • NOTE: An S-corporation is an election to be taxed a certain way for federal tax purposes, not a different kind of corporation
  • Limited liability company (LLC)
tax considerations
Tax Considerations
  • The reality of C-corp double taxation
  • Deductibility of flow-through losses
  • State income (or franchise/excise) taxation
  • Wage taxation/self-employment tax
  • Cost of tax reporting
  • Hassle factor (payroll tax filings)
  • Legal entity having separate existence recognized by state
  • Governed by board of directors elected by shareholders; directors responsible for hiring and overseeing executive management
  • May be only one shareholder, who serves as sole director and as president; must be at least one other officer (unless only one shareholder, in most states)
  • Bylaws are the constitution, defining how corporation will be governed
  • Shareholders not liable for debts and obligations of corporation, provided that corporate formalities adhered to
  • Policy is to encourage business risk-taking by protecting owners from liability, so long as persons dealing with corporation are on notice that it is a corporation
corporation continued
Corporation (continued)
  • Generally best choice for attracting outside capital
  • May have multiple classes of ownership
    • Common stock represents basic equity ownership
    • Preferred stock can be created to represent ownership that gets dividends ahead of common stock holders and/or that gets a specified rate of return before common holders get any cash and/or that has special voting privileges
corporation continued1
Corporation (continued)
  • Multiple classes of preferred stock can be created, each having different rights and preferences
  • Venture capital investors typically want preferred stock
  • In terms of distributions and voting, all common stockholders must be treated same, on pro rata basis; likewise, all holders of a given preferred stock class must receive equal treatment
corporation continued2
Corporation (continued)
  • For federal tax purposes, corporation is treated as a separate entity (a C-corp) unless it qualifies for and elects to be taxed like a partnership (S-corp)
  • Some states do not recognize S-corp status and tax the corporation as a separate entity; others require a separate election
  • Corporations (S or C) and partnerships (including LLCs) not permitted to be S-corp shareholders; neither are non-resident aliens
  • S-corporation limited to 100 shareholders and one class of stock (but S-corp is permitted to have differences in voting rights within single class of stock as long as all other rights are identical)
corporation continued3
Corporation (continued)
  • Election of S-corp status requires unanimous consent of current shareholders
  • Corporation can switch from S to C status and vice-versa (assuming it meets S-corp qualifications), but substantial tax effects may arise, especially from C to S
  • Cost of organizing a corporation generally less than setting up an LLC
sole proprietorship
Sole Proprietorship
  • Simplest form of business
  • Most widely used form of business, by far
  • Business is alter ego of owner
  • Single owner has complete control, but also full personal liability
  • Generally requires nothing more than filing a certificate of assumed name and obtaining a business license
  • All income and losses flow through to owner’s personal tax return
  • When owner dies, business dies
general partnership
General Partnership
  • Two or more persons (or entities) undertaking a business endeavor
  • Agreement as to respective duties and allocation of profits, losses, and cash flow
  • Agreement may be oral but should be written; implied by law when two persons act in concert to conduct business
  • Each partner is fully liable for 100% of the partnerships debts and obligations
general partnership continued
General Partnership (continued)
  • Each partner has a fiduciary obligation to the others, but one partner can unilaterally bind the others to a contract or incur liability for all
  • Tax effects flow through to partners; tax accounting rules can be very complicated
  • Partnership dissolves upon death or withdrawal of any partner
  • Not a good choice for most businesses; if two or more owners, a liability-shielded entity should be considered
limited partnership lp
Limited Partnership (LP)
  • Like a general partnership with shareholders
  • Must have at least one general partner with full liability (may be a person or an entity)
  • Unlimited number of limited partners, shielded from personal liability but also having very limited voice in management of business
  • Written partnership agreement and filing of certificate with state required
  • Tax effects flow through to partners, but almost inevitably extremely complex
  • Expensive to set up (accounting and legal costs)
  • Generally not well-suited for active business; frequently used for passive businesses such as commercial real estate
limited liability company llc
Limited Liability Company – LLC
  • Like corporation, LLC is legal entity separate from its owners (called “members”)
  • Depending upon your state, governed either by board of directors elected by members, by members as a group, or by managers selected by members (who may or may not be members themselves)
  • Operating agreement is the constitution for LLC, defining the rules for governance
  • Operating agreement also serves as the partnership agreement, defining how profits, losses, and cash flow will be allocated
  • Operating agreement also can serve the function of a shareholder agreement or buy-sell agreement
  • Relative complexity of operating agreement makes setting up an LLC more costly than creating a corporation
limited liability company llc continued
Limited Liability Company – LLC (continued)
  • LLC allows maximum flexibility in terms of governance and economic allocations
  • Single-member LLC now expressly or implicitly recognized in all states
  • Single-member LLC will be disregarded for federal tax purposes; owner (member) reports income on its tax return
  • Like shareholders in a corporation, members of an LLC are fully shielded from personal liability for debts and obligations of LLC provided appropriate formalities are followed
  • Unlike limited partners in an LP, members can be fully involved in management and control of LLC
  • Unlike S-corps, no restrictions on types of owner for LLCs
limited liability company llc continued1
Limited Liability Company – LLC (continued)
  • Until a few years ago, taxation of LLCs as partnerships (i.e., flow-through taxation rather than entity-level taxation) required careful planning and jumping through hoops; now LLC can merely “check-the-box” to elect to be taxed like a corporation (default is a partnership)
  • Price for tax flexibility of LLC is increased expense for preparing partnership tax returns (can be substantial if complicated structure involved)
  • LLC structure can be somewhat cumbersome for attracting outside institutional capital but may be desirable to an angel or other individual investor
tax considerations1
Tax Considerations
  • Tax is complicated
    • Generally, receipt of stock in exchange for contribution to corporation (C or S) is nontaxable (so long as 80% control test is satisfied), provided liabilities not in excess of tax basis of contributed assets (excluding trade receivables and trade payables)
    • Generally, receipt of membership interest in exchange for contribution to LLC (or partnership) is nontaxable unless it is a disguised sale (cash received), but members who contribute assets encumbered by liabilities recognize gain if allocation of liabilities creates negative capital account. Contributions of services may have tax consequences.
    • Even S-corp subject to double taxation if it distributes E&P left over from C-corp, or sells built-in gain property, or has excess net passive income; if C-corp on cash method makes S election, recognition of income from A/Rs will trigger built-in gains tax
  • In other words, consult an attorney or tax advisor
shareholder operating agreements
Shareholder/Operating Agreements
  • As a general proposition, equity interests in a company (whether stock, LLC membership, or LP interests) are assets that are freely transferable (subject to securities laws), may be pledged as collateral for a debt, and may be bequeathed by will
  • Consider these scenarios in a small company having three owners, all of whom are active in the business:
    • An owner dies, leaving her stock to her husband who has no business acumen and now is your business partner
    • An owner pledges his LLC interest for a loan, then defaults; now the bank is your partner and wants to liquidate the business
    • An owner leaves the company to work for a competitor; he still is entitled to financial and other information about the company
    • An owner gets divorced and his stock is awarded to his ex-wife; now he works for her
shareholder operating agreements continued
Shareholder/Operating Agreements (continued)
  • In a closely-held company, each owner typically relies heavily on the abilities and judgment of the others
  • All owners of a small business have a common interest in preventing outsiders from becoming partners without consent
  • Shareholder agreement (also called buy-sell agreement or stock restriction agreement) is a contract among owners of a company as to limitations on transferability and related contingencies
  • Separate document for a corporation, but often incorporated into operating agreement for LLC or into partnership agreement for LP
shareholder operating agreements continued1
Shareholder/Operating Agreements (continued)
  • Typical provisions:
    • Rules for decision-making
    • Prohibition on sale or transfer of interest or pledging interest as collateral without approval of majority of other owners
    • Company and/or other owners have right of repurchase (either for fair market value to be determined at the time or for a value based upon a specific formula) in the event of:
      • Death of owner and transfer of interest to estate
      • Divorce of owner and transfer of interest to ex-spouse
      • Bankruptcy of owner and transfer of interest to third party
      • Resignation or retirement of owner as employee
    • Voting rights suspended upon involuntary transfer
the right place which state s
The Right Place – Which State(s)?
  • Formation (domestication)
    • Corporation: Home state versus Delaware
      • Governance
      • Dispute resolution
      • VC funding
    • LLC: Not so much difference
  • Foreign qualification: primarily a tax concern
    • Locations of offices
    • Locations of employees
    • Locations of storage facilities
    • Other contacts with a state
the right time
The Right Time
  • Generally need a limited liability entity at the outset
  • May evolve in complexity as business partners, investors, and employee/owners come into picture
  • Form of organization can be changed as need arises
    • More tax efficient to change from LLC to corporation than to change from corporation to LLC
    • Don’t change withouttalking to your lawyer andaccountant
  • Evaluation of your ShareholderAgreements and PartnershipAgreements and OperatingAgreements